An IQ Test for Smart Beta Indexes

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Fundamentally-weighted indexes were introduced by Robert Arnott in 2004, and have come to be known as smart beta indexes because they are professed to outperform the market, as represented by traditional capitalization-weighted indexes. Hundreds of $Billions have flowed into smart betas, but not all of the fundamentally-weighted indexes are smart. In some cases, the alternative weightings create undesirable characteristics, so this blog is like a warning label. Caution: fundamental weighting may be hazardous to your wealth.

Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterpart, because this tilt has a history of performing better, so it may be smart. The future will tell us how smart this actually is. Fundamental indexes are created for broad markets, like the U.S. or Europe, and for market segments like style indexes. Fundamentally-weighted style indexes have a very low IQ for reasons I describe next. They are not smart.

The problems with “Smart” style indexes

PowerShares recently introduced fundamental style indexes called “Fundamental Pure Style Indexes”, or FPS. Style indexes are used in portfolios as completeness funds and to make style bets, like style rotation approaches. They are used in tandem with other investments, like active managers, to add value. As such, you’d prefer your indexes to be different from one another. Therein lies the problem in FPS. The FPS indexes are tilted toward value, so they are more clustered than capitalization-weighted style indexes, like my Surz Style Pure® indexes, as shown in the following exhibit. In a nutshell, value-tilting a growth index is not very smart. Note also that the FPS mid-cap growth (MG) index has a lower Price/Earnings ratio than the mid-cap value (MV) index, a perplexing anomaly.

Smarter Betas for Core-satellite investing

While we’re on the subject of index IQs, there is a very smart core index for core-satellite investing, far better than the S&P500. It’s shown in the graph above as “Centric.” Centric is defined as the stocks in between value and growth, so it makes a good complement to active value and growth managers. By contrast, the S&P500 dilutes active manager decisions by bringing in dead weight value and growth stocks that active managers deem unworthy. Centric is the absence of value and growth, while the S&P is value, growth, and centric.

Conclusion

We all want to be smart. In this blog you’ve learned how so-called “smart” can be dumb, and how a special kind of Core is far smarter than the traditional S&P500.

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